As we enter tax season, you may wonder what else you can do to pay fewer taxes. Perhaps your CPA or financial planner has been telling you to set up a cash balance plan or 401(k) for years, and you don’t know how to do it. Running a retirement plan can be a bit of work, but the tax savings are huge. Make 2025 the year you at least look at what a cash balance plan could do for your march toward financial freedom, or if nothing else, how it can reduce your taxes each year.
What Is A Cash Balance Plan?
A cash balance plan (CBP) is a type of retirement plan that combines features of traditional defined benefit plans and defined contribution plans. It provides participants with a specified lump sum at retirement, based on a formula that includes factors such as salary and years of service.
As a business owner, a cash balance plan is an amazing way to reduce your tax liability and play catch-up for retirement.
How Does A Cash Balance Plan Work?
A cash balance plan works towards providing you with a defined benefit at a specific age in retirement. For example, it could offer a pension income equal to 70% of your income at 65. This promised benefit would assume you worked for the company for some period of time.
You will need to refer to your company’s specific plan information to see what benefits you have already accrued and what you can expect in the future.
Who Is Eligible For A Cash Balance Plan
Eligibility for a CBP typically depends on the specific plan’s rules, but generally, it is available to employees of the sponsoring company. Most plans will have age and service requirements. There will also likely be a vesting schedule, meaning you will need to work for the company for at least some amount of time to get your full accrued benefits.
As of 2022, over 22,000 cash balance plans held over $1.2 trillion in assets. The huge run-up in incomes and the stock market in the last two years of the Biden presidency would lead me to believe that there are more plans in place today and substantially more assets in these valuable retirement plans.
How Do You Set Up A Cash Balance Plan (CBP)?
When we are talking about tax savings, the cash balance plan will look a lot like your defined contribution plan—think 401(k). In reality, a cash balance pension plan is a defined benefit plan. The employer will make contributions over time to help fund a “defined pension benefit.” The plan design guarantees the return on assets in the participants’ accounts.
When your investment selections perform better than the guaranteed benchmark return, your cash balance plan contribution the following year will be smaller. Conversely, if the plan’s investments do not meet or exceed the guaranteed return, the employer must eventually make up the difference. The good news here is that the shortfall allows for a larger contribution and more tax savings in the future. Also, the business owner has seven years to make up for the investment shortfall. This also gives the investment time to help make up some or all of the shortfalls.
How To Actually Set Up A Cash Balance Plan
Setting up a cash balance pension plan is much more complicated than opening an IRA or other investment account. You will need to work with your fiduciary financial planner, CPA and likely other professionals to ensure the plan is optimized for your specific needs and funding goals.
Your trusted financial advisor will first collect an employee census that outlines the demographics of your employees (if you have them), such as employee wages and salaries. With this demographic information, the pension planner calculates how much can go into the plan for executives and owners and how much will have to go in for the employees each year to pass IRS testing. There are strict rules to ensure that the plan’s benefits don’t discriminate in favor of officers, shareholders or any employees.
Step two for setting up a cash balance plan is putting together a legal document laying out all the plan’s details, including the contributions for the participants and the annual interest crediting. The Secure Act 2.0 is extended when the cash balance plan setup document must be signed. You have until September 15 of the following year to set up a cash balance plan for the prior tax year. However, waiting until the last minute may limit your options when designing the CBP to maximize contributions and minimize taxes.
What Are The Benefits Of A Cash Balance Plan?
There are quite a few benefits to using a cash balance plan. Large tax savings are the biggest drivers for business owners to fund a cash balance plan. Likewise, providing a cash balance plan for your employees can reduce turnover and increase employee loyalty. Lastly, a cash balance plan allows for substantially larger contributions than a 401(k).
Also, keep in mind that your cash balance plan contributions are in addition to what you may already be contributing to your 401(k) profit-sharing plan.
What Are The Drawbacks To A Cash Balance Plan?
Yes, there are some drawbacks to a cash balance plan. They are more complex and costly to administer than a basic 401(k) plan. Depending on plan design and number of employees, the employer contributions can be quite large. When looking to maximize the tax benefits of a cash balance plan, you may end up choosing more conservative investments, which will often lead to lower returns over time.
There are a few other things to keep in mind when running a cash balance plan for your business. This is not just a plan to set it and forget it. It will take a little bit of work each year. Luckily, your financial planner and the pension team can do most of this heavy lifting.
What Are The Cash Balance Plan Contribution Limits?
The plan’s design and IRS regulations determine contribution limits for a CBP. These limits can be higher than those for 401(k) plans, allowing for significant retirement savings.
I’ve seen many plan designs where the business owner is able to sock away $200,000-300,000 into their own retirement accounts. These numbers can easily double if your spouse is working in the business. The tax savings over a decade can easily be in the millions of dollars.
Who Would Benefit The Most From A Cash Balance Plan?
When it comes to my business owner clients, the cash balance plan is one of my favorite tax-planning tools. For the right business owner, the tax savings could be huge. With many successful business owners behind when it comes to funding a secure retirement, the higher contribution limits of a cash balance plan could help you play catch-up for retirement during your peak earning years.
Even with all the benefits of a cash balance plan, it is only suitable for some business owners. Here are some attributes of people who will benefit the most from setting up this type of retirement plan for their business.
- You are looking to increase your contributions to retirement accounts.
- You want to save more than is allowed in a basic 401(k) plan or SEP-IRA.
- You have a relatively consistent business income.
- Your household income is $280,000 or greater.
- You would like to save $50,000 or more on taxes each year.
- Your business has 16 or fewer full-time W-2 employees
- The business owner is older than the average employee.
- Extra Credit if you live in a high-tax state (higher state taxes = greater tax savings). I’m talking to you, California and New York business owners.
Cash Balance Plan Example
A successful business owner, age 55, wants to maximize his retirement savings and reduce his tax liability. He earns over $1 million annually, with a salary of $330,000. While this business owner has quite a few “employees,” they are all part-time or independent contractors and don’t need to be included in these retirement plans.
The cash balance plan design calculations allow the owner to contribute $260,000 pre-tax to the cash balance. He can also max out a 401(k) profit-sharing plan with additional pre-tax contributions of $77,500 (employee, employer and catch-up contributions) in 2025.
In a scenario like this, opening a cash balance plan is a no-brainer if you can contribute $300,000 per year to fund your retirement. The more employees you have, the less of the contribution will go directly to you as the owner. If you have less than 15 full-time employees, it’s worth crunching the numbers to see how a cash balance plan can be designed to meet your tax-planning and retirement-planning needs.
Not all financial advisors, CPAs or financial planners are willing or able to help you optimize and set up a cash balance plan. You should set up the plan for best results during the tax year. However, the deadline to set up and fund a cash balance plan is your tax-filing deadline, including an extension. So, there is still time to set up this tax-saving plan for 2024.